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Transfer Pricing: The New Temporary Cost-Sharing Regs.

By Jeffrey B. Kaufman, Phoenix, AZ

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Editor: Mindy Cozewith, CPA, M. Tax.

On December 31, 2008, the IRS introduced new temporary
cost-sharing regulations (T.D. 9441) that replace the old
cost-sharing regulations introduced in 1995. The goal of the new
regulations is to ensure that cost-sharing arrangements and
platform contribution transactions are consistent with Sec.
482’s commensurate with income (CWI) principle. To achieve that
goal, the IRS has introduced three new methods—the income
method, the acquisition price method, and the market
capitalization method—to ensure arm’s-length pricing in all
cost-sharing transactions. The comparable uncontrolled
transaction (CUT) method and a revised residual profit split
(RPS) method are also included as specified methods.

The
Nature of the CSA and CSA Transactions

The new
regulations apply only to cost-sharing arrangements (CSAs)
meeting the standards identified in Temp. Regs. Sec. 1.482-7T
and platform contribution transactions (as defined in the new
CSA regulations). Other transactions involving intangibles
should be analyzed using Regs. Sec. 1.482-4. To ensure
consistency with CWI, the new CSA regulations apply the concept
of an investor model based on the opportunity cost principle
from standard microeconomics. In economic theory, when people
make economic decisions they select the option they believe will
provide the greatest net gain. The opportunity cost of that
option is the next best alternative forgone. In the new CSA
regulations, the investor model requires the CSA participants to
look at realistic, alternative investment options that would
provide the same results as the CSA but with different risk and
functional fact patterns.

A CSA is an arrangement in
which controlled participants to the CSA share in the cost of
developing cost-shared intangibles in proportion to the share of
reasonably anticipated benefits (RABs) each participant expects
to receive (Temp. Regs. Sec. 1.482-7T(b)). In the CSA,
controlled participants must make payments to each other to
ensure that their cost contributions to intangible development
activities (IDAs) reflect their respective RABs. The scope of
the IDAs includes all activities that could reasonably be
anticipated to contribute to developing the reasonably
anticipated cost-shared intangibles.

The new CSA
regulations introduce the concept of a platform contribution
transaction (PCT) to replace the overly broad “external
contributions” from the 2005 proposed regulations. In a PCT, one
CSA participant contributes to a CSA an intangible that will be
used to help develop the CSA’s cost-shared intangible. Other
members of the arrangement (the PCT payors) must make
arm’s-length PCT payments to the participant who contributes the
PCT intangible (the PCT payee). The temporary regulations
require the PCT payor to compensate the PCT payee only for
platform contributions that can reasonably be anticipated to
contribute to the CSA activity in the PCT payor’s division. The
temporary regulations adopt a presumption that a PCT payee
provides any resource, capability, or right to the IDA on an
exclusive basis (Temp. Regs. Secs. 1.482-7T(b)(1)(ii) and
(c)).

The new CSA regulations require the CSA participants
to segment the interests of each CSA member into exclusive
divisions. In a division, each controlled participant must
receive a nonoverlapping interest in the cost-shared intangibles
without further obligation to compensate another participant for
such interest. For example, a CSA can segment interests by
assigning exclusive territories where each participant is the
sole beneficiary of sales in its exclusive region (Temp. Regs.
Secs. 1.482-7T(b)(1)(iii) and (b)(4)(ii)).

The new CSA
regulations allow the divisions to be created on nonterritorial
bases. One method a taxpayer can use is to identify specific
fields of use for the intangible and assign each participant
exclusive control over a field or set of fields. In the field of
use division, each controlled participant must own clearly
defined consumer uses for the intangible from which to earn its
RAB. An intangible product could have multiple market uses
generating multiple income streams. Each unique income stream
would need to be identified and assigned to a controlled
participant. Income from uses not yet identified would need to
be assigned to one participant as well (Temp. Regs. Sec.
1.482-7T(b)(4)(iii)).

Intangible Development Costs

The basis of any CSA is how to divide intangible development
costs (IDCs) of performing an IDA. Costs included in IDCs are
determined by the scope of IDA activity. The IDA is the activity
undertaken by the CSA participants to develop or attempt to
develop reasonably anticipated cost-shared intangibles. The
scope of the IDA includes all the controlled participants’
activities that could reasonably be anticipated to contribute to
developing the reasonably anticipated cost-shared intangibles
(Temp. Regs. Sec. 1.482-7T(d) (1)(i)).

The IDCs that
result from the IDAs include all costs, in cash or in kind
(including stock-based compensation, as described in Temp. Regs.
Sec. 1.482-7T(d) (3)), incurred by the CSA participants. Thus,
controlled participants to the CSA must include in the IDCs the
costs they incurred in attempting to develop reasonably
anticipated cost-shared intangibles, regardless of whether such
costs fail to develop those intangibles, unexpectedly develop
other intangibles, or produce no intangibles (Temp. Regs. Sec.
1.482- 7T(d)(1)(iii)).

The new CSA regulations are clear
about the requirement to include stock options in the IDCs. The
cost attributable to stock-based compensation is equal to the
amount the controlled participant is allowed to take as a
deduction for federal income tax purposes with respect to that
stock-based compensation and is taken into account as an IDC for
the tax year for which the deduction is allowable. The CSA
participants should value the stockbased compensation as of the
grant date (Temp. Regs. Sec. 1.482-7T(d)(1)(iii)).

The
new CSA regulations are based on the investor model and the
analysis of realistic alternatives to the proposed CSA (Temp.
Regs. Sec. 1.482-7T(g)(2)(ii)). The PCT payor is investing in
the CSA activity with cost-sharing payments and PCT payments to
realize a return over time that is consistent with the riskiness
of the project. The realistic alternatives to the investor
represent the opportunity cost of the project that a third-party
investor would have to consider before moving forward with the
CSA. The returns are measured using a present value
calculation.

The measurement of arm’s-length results
requires a complete best method analysis. To ensure that CSA
results are consistent with the arm’s-length standard, expected
returns to particular functions and risks in the investor model
assumed in intangible development should be assessed in light of
the facts and circumstances. The facts and circumstances of the
transaction will dictate the selection of a best method.

The results of a best method analysis performed in connection
with certain methods or forms of payment may depend on the rate
or rates of return used to convert projected results of
transactions to present value. Discount rate selection plays a
central role in the present value analysis. The allocation of
costs and establishment of cost contributions rely on forecasts
of future anticipated business activities and financial results
(Temp. Regs. Sec. 1.482-7T(g)(2)(v)).

The new CSA
regulations recognize that different realistic alternatives may
carry different risk profiles and require different discount
rates. A single method may require the use of multiple rates.
When selecting rates for inclusion in the best estimate of a
present value calculation, the taxpayer must identify the
rate(s) that most reliably assess the market risks of activities
and transactions. The new CSA regulations endorse the use of an
iterative approach when multiple rates are used to establish an
arm’s-length range (Temp. Regs. Sec. 1.482-7T(g)(2)(ix)).

CSA Arm’s-Length Calculation Using the RAB Method

For the arm’s-length allocation for IDCs under a CSA,
taxpayers should use the RAB method (Temp. Regs. Sec. 1.482-
7T(a)(1)). When determining RAB shares at any given time,
reasonably anticipated benefits must be estimated over the
entire period, past and future, of exploitation of the
cost-shared intangibles. A controlled participant’s RAB share is
equal to its RAB divided by the sum of the RABs of all the
controlled participants (Temp. Regs. Sec.
1.482-7T(e)(1)(i)).

Reasonably anticipated benefits are
measured either on a direct basis, by reference to estimated
benefits to be generated by the use of cost-shared intangibles
(generally based on additional revenues plus cost savings less
any additional costs incurred), or on an indirect basis, by
reference to certain measurements that reasonably can be assumed
to relate to benefits to be generated (Temp. Regs. Sec.
1.482-7T(e)(2)). Indirect bases for measuring anticipated
benefits from participation in a CSA include units used,
produced, or sold; sales; or operating profit. In some
circumstances, other bases for measuring anticipated benefits
may be appropriate.

The reliability of an estimate of RAB
shares also depends upon the reliability of related projections.
Projections required for this purpose generally include:

A determination of the time period between the
incep tion of the research and development activities under
the CSA and the receipt of benefits;

A
projection of the time over which benefits will be received;
and

A pro jection of the benefits anticipated
for each year in which it is anticipated that the cost-shared
intangible will generate benefits.

A projection
of the relevant basis for measuring anticipated benefits may
require a projection of the underlying factors. For example, a
projection of operating profits may require a projection of
sales, cost of sales, and operating expenses (Temp. Regs. Sec.
1.482-7T(e)(2)(iii)).

Income Method

Under the
new income method (Temp. Regs. Sec. 1.482-7T(g)(4)), a proposed
CSA advances a cost-sharing scenario between a PCT payor and PCT
payee, where the PCT payor makes payments for its share of the
platform intangible contributed by the PCT payee, and the
parties to the CSA agree to share in the costs of the IDAs. The
present value of the PCT payor’s cost-sharing alternative is the
present value of the stream of the reasonably anticipated
residuals, over the duration of the CSA activity, of divisional
profits or losses, minus operating cost contributions, minus
intangible cost contributions, minus PCT payments (Temp. Regs.
Sec. 1.482-7T(g)(4)(ii)).

The income method uses
realistic alternatives to measure the opportunity cost of the
proposed CSA. The method employs the CUT method and the
comparable profits method (CPM) to build up specified types of
comparable sets for the realistic alternatives. The income
method evaluates whether the amount charged in a PCT is
determined at arm’s length by reference to a controlled
participant’s best realistic alternative to entering into a CSA.
Under this method, the arm’slength charge for a PCT payment will
be an amount where the present value of the controlled
participant’s cost-sharing alternative, at the date of the PCT,
equals the present value of the next best realistic
alternative.

In general, the PCT payor’s best realistic
alternative to entering into the CSA would be to license
intangibles to be developed by an uncontrolled licensor that
undertakes the commitment to bear the entire risk of intangible
development that would otherwise have been shared under the CSA.
Similarly, the PCT payee’s best realistic alternative to
entering into the CSA would be to commit to bear the entire risk
of intangible development that would otherwise have been shared
under the CSA and license the resulting intangibles to an
uncontrolled licensee (Temp. Regs. Sec.
1.482-7T(g)(4)(i)(A)).

The new CSA regulations discuss two
applications of the income method licensing scenario, one using
a CUT method and one using a CPM. The licensing alternative is
derived on the basis of a functional and risk analysis of the
cost-sharing alternative, but with a shift of the risk of cost
contributions to the licensor. The PCT payor’s licensing
alternative consists of entering into a license with an
uncontrolled party, for a term extending for what would be the
duration of the CSA activity, to license the make-or-sell rights
in to-be-developed resources of the licensor. Under such
license, the licensor would undertake the commitment to bear the
entire risk of intangible development that would otherwise have
been shared under the CSA.

The present value of the PCT
payor’s licensing alternative may be determined using the CUT
method, as described in Regs. Secs. 1.482-4(c)(1) and (2). In
this case, the present value of the PCT payor’s licensing
alternative is the present value of the stream, over what would
be the duration of the CSA activity under the costsharing
alternative, of the reasonably anticipated residuals of the
divisional profits or losses that would be achieved under the
cost-sharing alternative, minus operating cost contributions
that would be made under the cost-sharing alternative, minus the
licensing payments as determined under the CUT method (Temp.
Regs. Sec. 1.482-7T(g)(4)(iii)(A)).

The present value of
the PCT payor’s licensing alternative may be determined using
the CPM, as described in Regs. Sec. 1.482-5. In this case, the
present value of the licensing alternative is the same as in the
CUT scenario, except that the PCT payor’s licensing payments are
determined to be a lump sum, as of the date of the PCT, equal to
the present value of the stream, over what would be the duration
of the CSA activity under the cost-sharing alternative, of the
reasonably anticipated residuals of the divisional profits or
losses that would be achieved under the costsharing alternative,
minus operating cost contributions that would be made under the
cost-sharing alternative, minus market returns for routine
contributions (Temp. Regs. Sec. 1.482-7T(g)(4)(iii)(B)).

Acquisition Price Method

The acquisition price
method (Temp. Regs. Sec. 1.482-7T(g)(5)) applies the CUT method
of Regs. Sec. 1.482-4(c) or the comparable uncontrolled services
price (CUSP) method described in Temp. Regs. Sec. 1.482-9T(c) to
evaluate whether the amount charged in a PCT is determined at
arm’s length by reference to the amount charged (the acquisition
price) for the stock or asset purchase of an entire organization
or portion thereof (the target) in an uncontrolled transaction.
The acquisition price method is ordinarily used where
substantially all the target’s nonroutine contributions made to
the PCT payee’s business activities are covered by a PCT. Under
this method, the arm’s-length charge for a PCT is equal to the
adjusted acquisition price, as divided among the controlled
participants according to their respective RAB shares.

Market Capitalization Method

The market
capitalization method (Temp. Regs. Sec. 1.482-7T(g)(6)) applies
the CUT method of Regs. Sec. 1.482- 4(c) or the CUSP method
described in Temp. Regs. Sec. 1.482-9T(c) to evaluate whether
the amount charged in a PCT is determined at arm’s length by
reference to the average market capitalization of a controlled
participant (PCT payee) whose stock is regularly traded on an
established securities market. The market capitalization method
is ordinarily used where substantially all the PCT payee’s
nonroutine contributions to the PCT payee’s business are covered
by a PCT.

Under the market capitalization method, the
arm’s-length charge for a PCT covering resources, capabilities,
and rights of the PCT payee is equal to the adjusted average
market capitalization, as divided among the controlled
participants according to their respective RAB shares. The
average market capitalization is the average of the daily market
capitalizations of the PCT payee over a period beginning 60 days
before the date of the PCT and ending on the date of the
PCT.

Residual Profit Split Method

The RPS method
(Temp. Regs. Sec. 1.482-7T(g)(7)) evaluates whether the
allocation of combined operating profit or loss attributable to
one or more platform contributions subject to a PCT is
determined at arm’s length by reference to the relative value of
each controlled participant’s contribution to that combined
operating profit or loss. The combined operating profit or loss
must be derived from the most narrowly identifiable business
activity (relevant business activity) of the controlled
participants for which data are available that includes the CSA
activity. The residual profit split method may not be used where
only one controlled participant makes significant nonroutine
contributions (including platform or operating contributions) to
the CSA activity.

The relative value of each controlled
participant’s contribution to the success of the relevant
business activity must be determined in a manner that reflects
the functions performed, risks assumed, and resources employed
by each participant in the relevant business activity. Such an
allocation is intended to correspond to the division of profit
or loss that would result from an arrangement between
uncontrolled taxpayers, each performing functions similar to
those of the various controlled participants engaged in the
relevant business activity.

Under the RPS method, the
present value of each controlled participant’s residual
divisional profit or loss attributable to nonroutine
contributions (nonroutine residual divisional profit or loss) is
allocated among the controlled participants that furnish
significant nonroutine contributions (including platform or
operating contributions) to the relevant business activity in
that division (Temp. Regs. Sec. 1.482-7T(g)(7)(iii)(A)).

The present value of nonroutine residual divisional profit or
loss equals the present value of the stream of the reasonably
anticipated residuals, over the duration of the CSA activity, of
divisional profit or loss, minus market returns for routine
contributions, minus operating cost contributions, minus cost
contributions, using a discount rate appropriate to such
residuals. The present value of nonroutine residual divisional
profit or loss in each controlled participant’s division must be
allocated among all the controlled participants based upon the
relative values (determined as of the date of the PCTs) of the
PCT payor’s PCT payments as compared with the PCT payee’s
nonroutine contributions to the PCT payor’s division (Temp.
Regs. Sec. 1.482- 7T(g)(7)(iii)(B)).

Comparable
Uncontrolled Transaction Method

The CUT method described in
Regs. Sec. 1.482-4(c) and the CUSP method described in Temp. Regs.
Sec. 1.482- 9T(c) may be applied to evaluate whether the amount
charged in a PCT is determined at arm’s length by reference to the
amount charged in a CUT (Temp. Regs. Sec. 1.482-7T(g)(3)). When
applied in the manner described in Regs. Sec. 1.482- 4(c) or Temp.
Regs. Sec. 1.482-9T(c), the CUT or CUSP method will typically
yield an arm’s-length total value for the platform contribution
that is the subject of the PCT. That value must then be multiplied
by each PCT payor’s respective RAB share in order to determine the
arm’s-length PCT payment due from each PCT payor.

EditorNotes

Mindy Cozewith is director, National Tax,
at RSM McGladrey, Inc., in New York City.

Unless otherwise noted, contributors are members of or
associated with RSM McGladrey, Inc.

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